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What Impact Will the Fiscal Cliff Have on MLPs?

A look at what the future holds for master limited partnerships.

President Obama's re-election helped restore some degree of certainty to the markets. But a number of concerns regarding tax and regulatory issues -- the most important of which is the looming "fiscal cliff" -- have recently gripped the markets in fear.

If Congress fails to reach a compromise on the so-called fiscal cliff, tax rates on dividends and capital gains will rise substantially next year. What will this mean for energy master limited partnerships, or MLPs?

The cliff! The cliff! The term "fiscal cliff" has been all over the news headlines recently. The ominous phrase refers to an up to $600 billion combination of expiring tax cuts, automatic spending cuts, and new taxes that is set to kick in at year-end if Congress fails to come up with a solution. Many pundits have proclaimed that this will tip the economy over the "cliff" and into the abyss of insurmountable debt.

According to economists, the consequences to the U.S. economy would be devastating. Going over the fiscal cliff would almost certainly invite a full-blown recession, with an impact that could be as great as 4.5% of US GDP.

However, the fiscal cliff's impact on tax rates for capital gains and dividends is perhaps the biggest issue weighing on investors' minds. If Congress doesn't manage to reach a compromise, taxes on dividends are set to rise to 39.6% next year, up from 15% currently. Uncertainty regarding taxation and other concerns drove an MLP sell-off, amid a broader market sell-off, in the first half of last month.

But energy MLPs' dividends -- or distributions -- are treated differently. So will the projected tax rate increases have any impact on them?

The fiscal cliff and MLPsThe market seemed to think so, judging by the MLP sell-off and a broader sell-off of energy stocks last month following the president's election. From Nov. 6 to Nov. 15, the benchmark AlerianMLP Index (INDEX: ^AMZ) plunged nearly 9 %, while the S&P 500 Energy Sector Index similarly declined more than 6% over the same period. While the Alerian MLP Index has since recovered modestly, it is still down slightly year to date.

This raises the question as to whether the MLP sell-off was due to investor concerns regarding the fiscal cliff and President Obama's ability to urge Congress in resolving it. If it was, then many investors may have misunderstood the cliff's consequences for MLP taxation.

In reality, any impact is likely to be negligible. After all, MLPs are tax-advantaged, pass-through entities that aren't required to pay corporate income taxes. This structure enables them to pay out the lion's share of their cash flow to unitholders in the form of quarterly distributions. These distributions aren't subject to qualified dividend income tax treatment.

So even if dividend taxes were to rise substantially, MLPs would not be affected. The share of MLP unitholders' income that is protected by non-cash depreciation is tax-deferred and treated as a return of capital, instead of as ordinary income. As such, roughly 80% of MLP distributions, on average, are tax-deferred, while just 20% of received income is taxable in the current year.

This actually amounts to a substantial advantage for MLPs. Contrary to what the recent sell-off would suggest, the asset class may actually offer protection against the impending fiscal cliff. If dividend tax rates rise next year, MLPs' after-tax yield would look highly appealing when compared with other income investments.

Credit Suisse's MLP picksA recent report by financial-services firm Credit Suisse reaffirms this view. As the firm notes, regarding the resolution of the fiscal cliff, no specific proposals have been put forth. But going by existing and proposed rules, MLPs won't be affected by the fiscal cliff. To the contrary, Credit Suisse believes that the high demand for crude oil infrastructure will actually continue to drive solid performance among MLPs.

The firm prefers operators such as Plains All American Pipeline(NYSE:PAA), Magellan Midstream Partners(NYSE:MMP), Enbridge Energy Partners(NYSE:EEP), Enterprise Products Partners(NYSE:EPD), Genesis Energy(NYSE:GEL), and the entire Kinder Morgan family, which includes Kinder Morgan Management(NYSE:KMR), Kinder Morgan(NYSE:KMI), and Kinder Morgan Energy Partners(NYSE:KMP), because of their "substantial exposure to the coming oil boom."

They also like high-quality MLPs with exposure to the market for natural gas liquids (NGLs), a group that the firm reckons should see healthy, stable growth thanks to additions of contracted fixed-fee assets. It listed DCP Midstream Partners(NYSE:DCP), Oneok Partners(NYSE:OKS), and MarkWest Energy Partners(NYSE:MWE) as names worthy of consideration. Amongst MLPs with exposure to natural gas, it likes El Paso Pipeline Partners(NYSE:EPB).

Final thoughtsIt's hard to say with complete certainty what the future holds for MLPs with respect to the fiscal cliff, because, so far, there have been no specific proposals put forth. But judging by current rules, the fiscal cliff is unlikely to have a meaningful impact on MLPs.

In any case, Congress probably won't eliminate MLPs' tax-advantaged status because the tax revenues it would potentially bring in are inconsequential. Also, given that the U.S. energy sector is one of the few beacons of hope for the economy, Congress is unlikely to tamper with anything that may discourage investment within the sector.

Going forward, I continue to view MLPs as one of the best income investments available today. They offer a high average yield, low correlations with other investments, and robust prospects for distribution growth, largely because of high and growing demand for oil and gas infrastructure.

Author

Arjun is a value-oriented investor focusing primarily on the oil and gas sector, with an emphasis on E&Ps and integrated majors. He also occasionally writes about the US housing market and China’s economy.